Abstract
Market-based dynamics can play a significant role in the development of green finance. Nevertheless, they will be unlikely effective to mobilise a sufficient amount of resources to properly contribute to finance the most ambitious environmental goals. This chapter analyses the main areas of intervention in the attempt to mainstream green finance, by pointing out in particular the importance of coherently factoring-in environmental risks in investors’ decision-making processes, of effectively channelling the market demand towards green securities, of encouraging the banking sector to embrace green finance and of pushing policy makers to promote and support green investments.
The authors would like to thank Rosita Fagiolo for her support to this chapter and the entire project of the book.
The contents included in this chapter do not necessarily reflect the official opinion of the European Commission. Responsibility for the information and views expressed lies entirely with the authors.
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Notes
- 1.
Sustainable finance can be broadly defined as the stocks and flows of financial resources and assets (across banking, investment and insurance industries) which is aligned with a large range of environmental, social and economic objectives and more generally with the delivery of the Sustainable Development Goals (SDGs) as developed in the context of the United Nation Development Programme (UNDP). In this respect, green finance should be considered a fundamental component of sustainable finance. For more details, see also Chap. 2 and UNEP (2016).
- 2.
These initiatives are described in Chap. 6.
- 3.
The information contained in this chapter are updated as of June 2019. The reader can verify the presence of updates on the European Commission’s activities for the development of sustainable finance here: https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance_en#overview
- 4.
Here we refer to investors as the ensemble of potential issuers and potential buyers of green securities.
- 5.
In many studies, this relationship has been proven even after taking into account the typical possible endogeneity problem (i.e. the fact that the most financially successful companies may be the ones that decide to be involved in sustainable initiatives). See again Friede et al. (2015).
- 6.
Organisations that have a dual bottom-line approach seek to extend the conventional bottom line, which measures economic and financial performance, by adding a second bottom line to measure their performance in terms of positive social impact. Ethical finance organisations and cooperative banks are examples of dual bottom-line organisations.
- 7.
As regards other possible incentives, little evidence still exists in particular concerning the presence of economic and financial benefits linked to the issuance of green securities (e.g. in the case of a lower cost of debit in case of the issuance of green bonds). Nevertheless, this situation may rapidly change, as a growing body of literature is emerging focussing on the impact of green labelling on the performances of financial securities. For more details, see Chap. 5.
- 8.
Possible early signs of a reduction in the growth of the green finance market are given by the green bond market in 2018, which experienced a reduction in the issuance in the first nine months of the year with the respect to the same period of 2017 (USD 108.3 bn, falling short of 2017 by about 1%). Source of data: Climate Bonds Initiative (2018).
- 9.
In this respect, the EU’s emissions trading system (ETS) needs to be mentioned as a way to force companies to internalise at least part of these risks. Launched in 2005, the ETS is a tool that supports the effort to cut GHG emissions by at least 40% by 2030 compared to 1990 levels. It obliges more than 11,000 power plants and factories to hold (and pay) a permit for each tonne of CO2 they emit, in order to provide a financial incentive to pollute less. Companies have to buy them through auctions and the price is affected by demand and supply (even though some of the permits are allocated for free, particularly in sectors at risk of having companies to move production to other parts of the world with laxer emission constraints). ETS encountered some technical issues linked to the unexpected fall of prices of permits after the crisis blasted in 2008, because of the drop-in demand, while the supply remained constant. In this respect, having a large surplus and low prices may effectively discourage companies from investing in green technology, thereby hampering the scheme’s efficiency. In addition, this (useful) tool alone does not guarantee to reach the EU targets following the Paris Agreement.
- 10.
Furthermore, the methodologies for properly calculating environmental risks are still in an early phase of development. Even if a promising movement in research, supported by policy makers is emerging, little empirical results are available today.
- 11.
Nevertheless, such a view is rapidly evolving. See Chap. 5 for a more detailed discussion of the financial performances of green securities.
- 12.
This also contributes to the above-mentioned lack of incentives for market investors to fully internalise some of these risks.
- 13.
This issue has been also addressed by the Central Banks and Supervisors Network for Greening the Financial System (NGFS), a group of Central Banks and Supervisors willing, on a voluntary basis, to exchange experiences, share best practices, contribute to the development of environment and climate risk management in the financial sector, and to mobilise mainstream finance to support the transition towards a sustainable economy. The Network brings together Banco de España, Banco de México, Bank Al Maghrib, Bank of England, Bank of Finland, Bank Negara Malaysia (Central Bank of Malaysia), Banque Centrale du Luxembourg, Banque de France/Autorité de Contrôle Prudentiel et de Résolution (ACPR), Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), De Nederlandsche Bank, Deutsche Bundesbank, European Banking Authority, European Central Bank, Finansinspektionen (Swedish FSA), Japan FSA, Monetary Authority of Singapore, National Bank of Belgium, Oesterreichische National Bank, the People’s Bank of China, the Reserve Bank of Australia, Reserve Bank of New Zealand.
- 14.
In addition, the lack of data on the impact of environmental risks may also generate situations in which financial intermediaries may decide to limit the provision of credit or insurance services to business or households potentially more concerned by these risks.
- 15.
The unexpected increase in the frequency and magnitude of climate-related extreme weather events is only one of the possible factors linked to climate change and potentially having an impact on the stability of the financial sector. In this respect, even policy actions can also bring some risks. This is the case when the physical assets used as collaterals for banking loans lose value resulting in non-compliance with new stricter environmental regulations (e.g. a building failing to respect new energy efficiency standards), or when the creditworthiness of banks’ clients owning physical assets decreases following a change in national policy (e.g. the owner of a coal power plant to be closed before expected and hence representing as a stranded asset).
- 16.
The mentioned report (IPCC 2018) gives a detailed analysis of the consequences of an increase of the global temperatures of 1.5 °C with respect to pre-industrial levels. Examples of climate-related extreme weather events are droughts, floods and storms. Some early evidence is also available on specific economic impacts. Based on Lancet (2017), between 2000 and 2016, annual weather-related disasters worldwide rose by 46% and, between 2007 and 2016, economic losses from extreme weather worldwide rose by 86% (EUR 117.0 bn in 2016).
- 17.
Or new risks insured on the basis of data not taking into account climate-related extreme weather events.
- 18.
In more detail, climate-related extreme weather events can produce damages that can result in a reduction of the value of the assets held by financial institutions and of the collateral backing banks’ loans, as well as in the impossibility of firms and households to repay what they have borrowed.
- 19.
Such an approach will avoid the alternative (but indeed possible) option through which banks and insurances companies would charge higher interest rates on credits and higher premiums on insured risks to clients irrespectively from their effective contribution to generate environmental risks. In point of fact, even though this option will probably reduce the systemic risks on the bank and insurance industries linked to environmental risks, it will result in an undue burden on non-polluting firms and households and would not represent an incentive for polluters to improve their environmental footprint. In addition, no reduction of environmental-related risks will eventually occur.
- 20.
Action 6 of the action plan for financing sustainable growth. In this respect, the Commission plans to (i) engage with all relevant stakeholders to explore the merits of amending the Credit Rating Agency Regulation to mandate credit rating agencies to explicitly integrate sustainability factors into their assessments in a proportionate way to preserve market access for smaller players, (ii) invite the European Securities and Markets Authority (ESMA) to assess current practices in the credit rating market, analysing the extent to which environmental, social and governance considerations are taken into account and to include environmental and social sustainability information in its guidelines on disclosure for credit rating agencies and consider additional guidelines or measures, where necessary and (iii) carry out a comprehensive study on sustainability ratings and research to analyse methodologies and explore aspects like the market structure of sustainability ratings and market research services, the depth and breadth of sustainability research assessments and scoring, and the independence of those research/scoring providers. See also Chap. 6.
- 21.
Considering the emergence of green labels in the financial markets, it is worth mentioning that mainstreaming green finance only partially implies labelling securities as green securities. Indeed, labels may represent useful tools for market players to easily screen the possible investment options and hence steer the market demand. Nevertheless, they imply an increased cost for issuers and their use should be constantly monitored in order to avoid opportunistic behaviours (as, but not limited to, the practice of greenwashing). As a matter of fact, in the policy perspective green labels should be henceforth considered as instruments more than final objectives.
- 22.
The counselling activity of financial intermediaries is regulated by the Market in Financial Instruments Directives and Market in Financial Instruments Regulation (MiFID I, MiFID II and MIFIR), in particular vis-à-vis retail clients, for which an analysis of suitability and appropriateness of the investment is mandatory.
- 23.
With respect to the European Commission action plan for financing sustainable growth (EC 2018), this is the case of the establishment of an EU classification system for sustainable activities (action 1), the creation of standards and labels for green financial products (action 2), the incorporation of sustainability when providing financial advice (action 4), the strengthening sustainability disclosure and accounting rule-making (action 9). Following the plan, in May 2018 the European Commission adopted a package of implementing measures including: a proposal for a regulation on the establishment of a framework to facilitate sustainable investment (this regulation establishes the conditions and the framework to gradually create a unified classification system—or taxonomy—on what can be considered an environmentally sustainable economic activity); a proposal for a regulation on disclosures relating to sustainable investments and sustainability risks and amending Directive (EU)2016/2341 (this regulation aims at introducing disclosure obligations on how institutional investors and asset managers integrate environmental, social and governance factors in their risk processes); a proposal for a regulation amending the benchmark regulation (to create a new category of benchmarks comprising low-carbon and positive carbon impact benchmarks, which should provide investors with better information on the carbon footprint of their investments). See also Chap. 6.
- 24.
It can also be argued that some of the environmental objectives may be left uncovered in the case investors factor-in only the environmental risks having some form of economic or financial impact. In fact, some of the environmental risks (e.g. the loss of the biodiversity) may have only a very weak relation with economic and financial risks. Similarly, factoring-in environmental risks to the extent to which they have economic or financial consequences may still produce a degradation of the environment of a higher level than societally acceptable.
- 25.
See, for example, Migliorelli and Dessertine (2018).
- 26.
See for example the case of the agriculture discussed in Chap. 8.
- 27.
Nevertheless, such an intervention should be justified by a detailed assessment in order to verify the effective presence of market failures or suboptimal investment situations. In the EU this practice is already adopted by policy makers in several programmes, through the so-called ex-ante assessments (see, e.g. the Methodological handbook for implementing an ex-ante assessment of agriculture financial instruments under the EAFRD). In this respect, policy-driven financing in the absence of market failures or suboptimal investment situations may result to go against state’s aid legislation.
- 28.
- 29.
The total assets of the European banking sector peaks up to 350% of aggregate GDP, while the same metrics is about 77% in the United States. Source: EBF (2012).
- 30.
The importance of banking in the context of sustainable finance has been recognised also by the United Nations Environment Programme (UNEP), which in 2018 identified six Principles for Responsible Banking, referring to: alignment (to the Sustainable Development Goals, the Paris Climate Agreement and relevant national and regional frameworks), impact, clients and customers, stakeholders, governance and target setting, transparency and accountability.
- 31.
The very first definitions of green loans have already emerged in the market, even though they are scarcely or not used in the banking sector. In particular, in March 2018 the Loan Market Association (LMA) published the first Green Loans Principle (GLPs), mainly mimicking the Green Bond Principles (GBPs) initiative. In the framework established by the LMA, green loans are defined as any type of loan instrument made available exclusively to finance or re-finance, in whole or in part, new and/or existing eligible green projects. To be recognised as such, the concerned organisations have also to align with the four core management components of use of proceeds, process for project evaluation and selection, management of proceeds and reporting (LMA 2018). In addition, it seems reasonable to argue that the same taxonomy that could be developed for listing sustainable activities should also be used for the identification of green loans.
- 32.
Action 8 of the action plan for financing sustainable growth. In this respect, the Commission plans to (i) explore the feasibility of the inclusion of risks associated with climate and other environmental factors in institutions’ risk management policies and the potential calibration of capital requirements of banks as part of the Capital Regulation and Directive and (ii) invite the European Insurance and Occupational Pensions Authority (EIOPA) to provide an opinion on the impact of prudential rules for insurance companies on sustainable investments. The mentioned supporting factor will be eventually phased-in along with the establishment of an EU classification system for sustainable activities (action 1 of the plan). For more details, see Chap. 6.
- 33.
This action adds to the actions linked to the definition of a taxonomy for sustainable activities and specific labelling criteria for green financial products, already discussed and not focused on banks, insurance companies and pension funds. Finally, it would be indeed necessary that the classification of green loans at banks’ level results from a process featured by low operational costs and high reliability. In this respect, it seems likely that the banking industry would be required to put in place specific operational processes and organisational structures (within the policy framework that will progressively consolidate) aimed at streamlining the concerned banking operations.
- 34.
Usually, at least three tranches are issued (senior, mezzanine and equity tranches) with a hierarchical right on the SPV repayments.
- 35.
In this regard, excess spread (the practice of issuing notes with an overall yield lower than that of the underlying assets) and overcollateralisation (the practice of issuing an amount of notes lower than the available underlying assets) are also used as sources of internal credit enhancement and to cover transaction costs linked to the securitisation operation.
- 36.
See also Duffie (2008) on the use of securitisation mechanisms backed by SMEs lending and short-term commercial papers, Caballero and Krishnamurthy (2009) on the creation of securities classes able to appeal to a large base of investors with different risk appetites and Cardone-Riportella et al. (2010) and Farruggio and Uhde (2015) on the benefits sought through securitisation as concerns the provision of new liquidity for financial intermediaries.
- 37.
Despite these advantages, existing literature highlights certain risks linked to securitisation practices. To this extent, a number of works have analysed the effects of the information asymmetries and the moral hazard that may feature the relationship between originator and final investors. In fact, banks and other financial institutions may tend to accept reducing their credit standards and transfer the risk to the market. In this respect, evidence has been documented, in particular for the subprime mortgages in the United States, which has been accused of triggering the financial crisis in 2007. Based on these studies, the absence of skin in the game has been the basis of a misalignment in the incentives between originators and final investors. This phenomenon has eventually caused a sensitive reduction of the quality of the underlying assets (e.g. Keys et al. 2009; Mian and Sufi 2009). For this reason, all recent regulation proposals on securitisation have included risk retention clauses concerning the originator. In more detail, the provision of maintaining a minimum nominal value of the first-loss tranche or of each of the tranches sold or transferred to investors is constantly proposed to limit opportunistic behaviours (BCBS 2014; IMF 2015; EC 2015).
- 38.
See also Arezki et al. (2017).
- 39.
Nevertheless, and depending of the specific structuring of the operation, provisions to avoid possible opportunistic behaviour of private investors and to adequately price the effective risk undertaken by the different parts have to be foreseen. This is valid in particular in the case governmental entities covering the project’s first loss.
- 40.
The latest global estimates of investment needs may differ, but they all point to a financing gap of trillions of dollars per year until at least the year 2030. Only as concerns investments in green, low-carbon and climate-resilient infrastructures, investment volumes can be estimated to range from USD 3.4 trillion to USD 4.4 trillion globally (source: OECD 2018).
- 41.
In the EU, organisational structures have been created with the aim, inter alia, to foster a pipeline of projects to achieve the goals of the European fund for strategic investments (EFSI). These structures are the European investment advisory hub and the European investment project portal. The main purpose of the advisory hub is to provide advice to investors, project promoters and public managing authorities on project identification, development and preparation. The advisory hub provides its services at both the EU and local level. The project portal’s purpose is to provide information for potential investors about projects that require investors, to increase their visibility and thus contribute to the effectiveness of the European fund for strategic investments. The portal displays projects for information purposes only: the projects featured on the portal have not been pre-selected for financing from the European fund for strategic investments or EU programmes.
- 42.
CICERO’s Second Opinions, S&P’s Global Ratings Green Evaluation and Moody’s Green Bonds Assessment have emerged as some of the main reference initiatives. CICERO uses four classes: dark green, medium green, light green and brown. S&P foresees five classes: GB1 (excellent), GB2 (very good), GB3 (good), GB4 (fair), GB5 (poor). Moody’s considers four main classes (E1, E2, E3, E4) and an overall score out of 100.
- 43.
In this respect, it is worth mentioning that, as for ratings on debt issuances, the request to have a rating comes from the issuer.
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Migliorelli, M., Dessertine, P. (2019). From Transaction-Based to Mainstream Green Finance. In: Migliorelli, M., Dessertine, P. (eds) The Rise of Green Finance in Europe. Palgrave Studies in Impact Finance. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-22510-0_7
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